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Climate change and real estate: Why risk managers need a seat on the investment committee

According to Schroders Real Estate, out of the five major cities most vulnerable to climate change around the world, four are in Asia: Tokyo, Shenzhen, Hong Kong and Shanghai.1 With real estate accounting for almost 40% of global carbon emissions,2 most major property owners have put in place specific targets to reduce their carbon footprint. Developers in Asia have also responded: Outside the US, China tops the list for having the most LEED-certified built area in 2022, followed by India. South Korea and the Philippines also made the top 10.3 

The shift towards sustainability in the real estate sector extends beyond developers to encompass investors as well. Increasingly, real estate investors are incorporating ESG criteria into their investment strategies, with ESG considerations factored into their operations. Real estate investors’ emphasis on ESG due diligence extends across the entire property lifecycle, encompassing acquisitions, leasing and asset management.

Yet, challenges persist. While significant effort has been put towards addressing immediate impacts, in particular attracting and retaining tenants, progress in combating long-term physical risks has been less tangible . In this respect, two issues have represented significant obstacles for investors. Firstly, the consensus among real estate investors is that the impact of climate change will largely manifest itself beyond investment time horizons and, secondly, the lack of confidence from real estate investors in pricing and mitigating longer-term risks. To address and overcome these problems, risk managers need a seat on investment committees so decisions can be risk-adjusted for climate change. 

Given the pronounced vulnerability of Asia's major cities and the real estate sector's sharpened focus on ESG, there is a pressing need to confront and address the longer-term physical risks. Risk managers working with experienced risk advisors, can prove instrumental to the success of investment strategies by ensuring that potential asset mispricing, anticipated value over the investment horizon, cash flow implications and influence on project returns, as well as the overall impact on valuations in a climate-altered future are all taken into account.

Understanding investor issues amid escalating climate challenges

In the world of real estate investment, particularly against the backdrop of increasing climate change concerns, several challenges are becoming increasingly evident. 

Insurer appetite and requirements are changing

One of the primary pain points real estate investors are grappling with is surging property insurance premiums in areas exposed to natural catastrophes (Nat Cat). As the threats from natural disasters become more pronounced, properties in vulnerable areas are witnessing premium inflation, posing challenges to investors’ returns.

Insurers are key to the conversation. Property damage from Nat Cat has generated losses for the global underwriting business each year for over a decade and insurers are taking steps to remedy these losses, partly by making coverage more restrictive and costly and also being highly selective of the assets they cover. Insurers are also asking the insured to absorb part of property risk through higher deductibles or self-insured retentions. 

Coupled with this is a laser focus on risk data. Insurers are requesting exhaustive risk data, asking for site surveys to be carried out and verifying that previous survey recommendations have been acted upon. Given the inflationary environment, it is also crucial for insureds to update their property valuations to ensure accuracy and avoid unintentional underinsurance, which will subject claims to the average clause. When the average clause is applied, the insured must then bear a proportion of their losses based on the percentage of underinsurance versus asset valuations.

Hence, accurate risk quantification by an expert and sharing an accurate risk profile is essential to paving the way for coverage that truly reflects and protects an asset’s unique vulnerabilities. This will in turn enable the design of bespoke insurance coverage that addresses the multifaceted challenges of climate change while anchoring projected returns amidst volatility.

Navigating regulatory and stakeholder complexities

As real estate investors grapple with the challenges of a changing climate, they must also navigate a maze of regulatory and stakeholder complexities. Evolving regulatory guidelines and increased expectations from stakeholders have resulted in a demand for greater transparency and responsibility.

Regulation has become a thorny issue. There is an amplified push for climate disclosure mandates amid increasingly stringent regulatory requirements such as the Hong Kong Monetary Authority (HKMA) regulations on “De-risking and Financial Inclusion”. By mandating greater transparency and due diligence from listed property owners, managers, and Real Estate Investment Trusts (REITs) on their climate risk exposure, these regulatory demands place added pressure on real estate entities.

Beyond the regulatory aspect, real estate owners and investment companies are also under increasing scrutiny from stakeholders and shareholders. With climate change advocacy continuing to hold organisations accountable for their investments and corporate actions, it is recommended for the risk manager to properly align the organisation towards sustainability and ethical norms, and to build a robust crisis management and communications plan integrated into an existing enterprise risk management framework.

Ensuring business continuity amid volatility

Investors need to revisit and assess the comprehensiveness of their existing business continuity plans (BCPs). Existing strategies that do not rely on accurate climate modelling data may not fully capture the evolving nature and nuances of extreme weather events and climate-related disruptions. The greater losses borne by insurers have also led to higher costs for insureds, reducing net operating income and emphasising the need for elevated measures that mitigate the frequency and intensity of losses, both now and in the future.

Investors will also need to respond to market forces and consider how climate change may impact a property beyond their investment horizon. Forecasting models are now more robust on an asset level and future purchasers will look to ascertain if cash flows may become impaired. Any impact can potentially affect the seller’s exit yield at the end of their hold period. As such, regular updates on climate science and prediction models can help ensure their BCPs remain relevant and responsive to the latest data and scenarios.

The key for real estate investors is to adopt a proactive approach to business continuity planning, in addition to fostering a collaborative, transparent relationship with insurers through their risk managers.

Charting the way forward

In light of multifaceted climate challenges, one thing becomes abundantly clear: Real estate owners and investment companies need to adopt a holistic approach towards climate change risk management. The advantages of a risk manager working with an experienced risk advisor and insurance broker are twofold: first in harnessing their data, technology and expertise in identifying climate risk blind spots and prioritising meaningful action, and secondly leveraging their network of insurers to build bespoke, cost-effective risk transfer solutions that provide adequate coverage against climate perils.

These considerations underline the value of a risk advisor to a real estate owner or investment company. Working hand-in-hand with risk managers with a seat at the investment committee, organisations will not only gain a more complete understanding of climate change risks and challenges, but also be able to assess the possible solutions and choose the right course of action. This is more than just an inclusion; it is a strategic move that ensures executive decisions are woven with foresight, balanced with caution, and primed for long-term viability amidst mounting climate challenges.

For more insight into understanding and measuring the cost of climate risk, both physical and transitional, and the effect on project returns and asset values, schedule a chat with a Marsh Real Estate representative today.